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Review Questions, Chapters 12-14

1.What is a production function? Write an equation for a typical production function,


and explain what each of the terms represents

Y = A F(L, K, H, N)
Y/L = A F(1, K/L, H/L, N/L)

Y=quantity of output
A=production technology
L=labor supply
K=physical capital
H=human capital
N=natural resources

2. The catch-up effect says that countries with low income can grow faster than
countries with higher income. However, in statistical studies that include many diverse
countries we do not observe the catch-up-effect unless we control for other variables
that affect productivity. Considering the determinants of productivity, list and explain
some things that would tend to prohibit or limit a poor country’s ability to catch up
with the rich ones.
A country may be restricted by its natural resources. This would limit
productivity and there really isn’t much a country can do to change their natural
resources, especially if it doesn’t have enough money to import them from other
countries. Also, poor healthcare is an ongoing cycle that limits productivity and
prevents a poor country from catching up to a rich country. As people can’t afford
adequate health care, human capital and productivity go down. As productivity goes
down, healthcare becomes worse, which in turn causes productivity to decrease
even more. Technological knowledge and education may also limit a poor country’s
ability to catch up with the rich ones. The tradeoff between saving and investment
also plays a role in a country’s ability to develop.

3. Explain what the productivity slowdown and speedup are. What do economists
believe was the cause of the slowdown?
The productivity slowdown and speedup explain the concept of diminishing
returns. As a poor country first starts to invest more in capital, productivity will rise
more than if a developed nation invested in the same amount of capital. Though
capital investment and productivity are proportional, it isn’t a linear relationship.
This is because wealthier nations typically have more capital than poor nations, so a
small increase in capital won’t have as much of an effect as it would in a poor
country. For example, if one country has 100,000 tractors, the addition of one more
tractor won’t make too big of an impact. But the addition of one tractor to a country
that only has 5, would increase output substantially.
4. compare and contrast the population theories of Malthus and Kremer.
 Malthus
o Increasing population would strain society’s ability to provide for
itself—mankind is doomed to forever live in poverty
o “power of population is greater than the power in the earth to
produce subsistence for man.”
o Attempts by charities or governments to alleviate poverty were
counterproductive
o May have been true when Malthus lived, but obviously, they didn’t
stay true—population has since increased, but so has standard of
living
 Productivity per laborer has increased because of technology
and better political policies
 Kremer
o Over the broad span of human history, world growth rates have
increased with world population.
o Technological progress is more rapid when there are more people to
discover things, so larger regions experience more rapid growth.
o A large population is a prerequisite for tech

6. Discuss the basic differences between bonds and stocks


Bond- debt finance
 Certificate of indebtedness that specifies the obligations of the borrower to
the holder of the bond—an IOU—business loan
 Paid back at the date of maturity with a rate of interest
 Initial money is called the principal
 Term
o The length of time until the bond matures
o Long term bonds are riskier so they have higher interest
 Credit risk
o Probability that the borrower will fail to pay some of the interest or
principal—default
o US government is considered a safe credit risk an dpays low interest
rates
 Tax Treatment
o The way the tax laws treat the interest earned on the bond
o Bonds issued by state and local governments pay a lower interest rate
than bonds issued by corporations or the federal government
Stock- equity finance
 A claim to partial ownership in a firm—claim to part of the profits that the
firm makes
 If a firm makes a ton of money, only stockholders see the benefits, bond
holders don’t
 If a firm runs into trouble, bondholders are paid what they are due before the
stockholders receive anything
 Stock- higher risk and higher return
7. a- Brazilian gov’t bc higher credit risk
b- government bonds because earnings on government bonds will be taxed
c- 20 year bond
d- new record company- more risk

8. In the national income accounting identity showing the equality between national
saving and investment, what is the representation of private saving and what is the
representation of public saving? Show the method used to reach these representations.
Y=GDB
C=consumption
I=investment
G=government purchases
NX=net exports

S=National savings= private savings + public savings


T=government collected taxes minus the amount it pays back to households

Closed economy-
Y=C+I+G
Y–C–G=I
(Y – C – G) represents GDP minus consumption and gov’t purchases, resulting
in national saving so
S=I
S=Y–C–G
S = (Y – C – T) + (T – G)
Private Public

If T>G there is a budget surplus


If G>T there is a budget deficit

9. Identify and explain why each one of the following represents either saving or
investment
a- saving: he hasn’t purchased or invested in any new capital
b- saving: she hasn’t purchased or invested in any new capital
c- investment- he purchased capital
d- saving
e- investment
12. As the interest rate increases, what happens to the present value of a future
payment? Explain why changes in the interest rate will lead to changes in the quantity
of loanable funds demanded and investment spending. Show and explain the equations
for future and present value. What is the “rule of 70” and how does it relate to present
and future value?
The present value will decrease because
PV = X/(1 + r)N So PV is inversely related to r

Graph-

FV = X(1 + r)N
PV = X/(1 + r)N

Rule of 70- if some variable grows t a rate of x percent per year, hen that variable
doubles in about 70/x years.

13. Give two examples of adverse selection and moral hazard in the insurance
industry.

Adverse Selection- A high risk person is more likely to apply for insurance than a
low-risk person because a high-risk person would benefit more.
Ex: Someone who speeds and drives aggressively is more likely to buy car insurance.
Someone who shops a lot is more likely to buy clothing insurance.

Moral Hazard- after people buy insurance, they have less incentive to be careful
about their risky behavior because the insurance company will cover much of the
resulting losses.
Ex: Someone runs a red light because they know they have car insurance. Someone
goes swimming with sharks because they know they have health insurance.

14. What is the difference between market (aggregate) risk and firm-specific
(idiosyncratic) risk? Will diversification eliminate one or both? Explain.

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